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Friday, November 21, 2008

Europe's Smoot-Hawley?

Negotiations on the EU climate package may or may not be completed by the end of this year. Even if a political deal is done, the hugely important issue of which industrial sectors will receive 'preferential treatment' will still need to be resolved - this could take up to 2011, according to the terms of the directive.

This might sound like an arcane subject, but it will have profound implications for the very existence of certain heavy industries in Europe after the reformed Emissions Trading Scheme begins in 2013 - and by extension, the structure of global trade.

To say businesses are concerned is an understatement. For energy-intensive industries subject to high levels of international competition, this really is a matter of life and death. They will not be able to remain in Europe if they need to pay for carbon permits or shoulder significantly higher energy costs.

With the stakes this high, there will be a huge fight over which industries are given special protection by the EU.

The German Environment ministry has produced a very helpful graph on the subject (click to enlarge). Basically, the higher the 'trade intensity', the less potential for the sector in question to pass through a higher carbon price to consumers (because of the effects of steep international competition). When high trade intensity is combined with a high carbon cost (as a percentage of gross value added), this spells big trouble for the industy sector concerned.

Chemicals, paper, aluminium, steel, glass and fertilisers look particularly exposed, but many sectors will be affected.

What measures can be taken to stop industries going offshore? Handing out free carbon permits for these sectors is the preferred solution for the UK government. However, this poses problems for industries (such as aluminium and chemicals) for whom the main cost burden of carbon pricing is indirect - ie. as a result of higher electricity prices. Furthermore, this solution could just provide industry with an incentive not to produce in Europe. By scaling down production here, and shifting it overseas, companies would be able to sell off their freely acquired permits for a profit.

Working on the assumption that European governments do want to keep heavy industrial jobs in Europe, this makes it very likely that we are heading for 'border tax adjustments': new tariff barriers in plain English.

The possibility of introducing these 'green tariffs' is indeed very clearly written into the draft Directive, and is a solution favoured by a protectionist camp of countries led by France. As the German graph illustrates, there is a very wide range of industries which will want to stake their claim to EU 'protection'.

Green tariffs would of course need to be applied to all imported finished goods assembled from the basic industrial products in question.

There would be the hellish task of trying to work out the relative carbon value of cars, electronic equipment or toys manufactured from a number of different components, often in a number of countries with differing environmental standards... There will be a feeding-frenzy for lobbyists in Brussels, seeking to fill this 'information gap' and secure special treatment for their industry.

If there is one lesson we can take away from the 1930s, increasing tariff barriers and slowing down international trade a surefire way to turn recession into global depression.

The EU climate package is a driver of protectionism. It risks creating major economic distortions, new barriers to international trade and possible retaliatory tariffs from other trade blocs.